August 23, 2021 – Daniel Zalipski, CFA®
Stock prices are influenced by several factors, both technical and fundamental. Technical factors are commonly thought of as external factors that influence a stock’s price, such as liquidity or regulatory action. Fundamental factors tend to focus on a company’s earnings and their valuation; the price investors are willing to pay for their claim of future earnings. As we pass the mid-point of the quarter, it is time to check in on earnings and valuations within the broader market.
At the time of this writing, 91% of S&P 500 companies are reported their Q2 2021 results. Of those that have reported, an astonishing 87% have beat the estimates. The S&P 500’s earnings growth is at 89.3%, well above the initial estimates of 64% at the start of the quarter, and the highest rate since 2009. It goes without saying these results are very strong, but it is important to remember the base effect. The results are presented as a year-over-year number, resulting in an extraordinarily large gain compared to the pandemic-depressed earnings from the prior year. Looking forward, earnings’ growth is expected to remain positive but decelerate from these elevated post-pandemic levels.
Valuations help investors determine if a stock appears expensive or cheap relative to its earnings. One of the most common valuation metrics is the P/E ratio, expressed as a multiple of price divided by earnings. When an investor buys a stock, they are buying a claim on future earnings. The valuation multiple, the price they pay for those earnings, can act as a guide. P/E ratios can be compared between individual companies or between a company and its sector or broad market. In addition, the P/E ratio for a company can be compared to its own past P/E ratio to get a sense if its trading at a premium or discount relative to the company’s own history.
The S&P 500’s forward P/E ratio (price divided by expected earnings over the next 12 months) currently sits at 21.1x compared to a 5-year average of 18.2x. Higher multiples make some nervous as reversion to the mean would result in downward pressure in stock prices. With interest rates near zero impacting the return potential of bonds and cash, the subsequent demand for stocks can easily result in higher multiples. Valuations certainly appear to be elevated relative to the recent past as investors pay-up for earnings.
Surprisingly, the strong earnings numbers are helping reduce overall valuations. Simply stated, earnings were increasing faster than stock prices, resulting in downward pressure in the P/E ratio. Another positive note, earnings growth estimates for next quarter are trending higher as analysts believe the post-covid recovery is still underappreciated. If earnings continue to surprise, the potential for further downward pressure on valuations is possible, resulting in more reasonably priced stocks.
There are always risks. Any acceleration in adjusting Fed policy, either through tapering asset purchases or increasing interest rates, has the potential to cause volatility within the market. The current inflation landscape, should it be more sustainable than expected, could potentially result in profit margin erosion as companies decide how and if they can pass cost increases to the consumer. Lastly, the ongoing delta variant spread has the potential to alter or reduce economic activity should consumers decide to scale-back and play-it-safe. For now, the focus remains on the on-going recovery. We remain invested and diversified and continue to monitor the broader market and economy.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to, nor does it represent or reflect, transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to, nor does it represent or reflect, transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.